How is trading cryptocurrency different from stocks and forex trading? originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.
Answer by John Hwang, Former Senior Options Trader at Morgan Stanley, on Quora:
Many newcomers to cryptocurrencies believe that investing in cryptocurrencies/tokens through a cryptocurrency exchange is like buying stocks at Fidelity or ETrade. The truth couldn’t be any more different. There are many, many more differences, but here are a few..
#1 Unmitigated exposure to insider trading and pump and dump schemes
In any asset, there is significant informational asymmetry between insiders and outsiders. In stocks, insiders are people like executives and mutual funds who have material, unfair advantage over outsiders who don’t have access to the latest financials, board room meeting minutes, etc. In cryptocurrencies, insiders are 1) the executives of the companies behind cryptocurrency tokens, 2) mining pools, and 3) large holders (i.e. “whales”). Regardless of the asset, insiders have access to critical information sooner than the outsiders, which allows them to buy before rallies, or sell before selloffs.
Unless you are an insider, this informational asymmetry is bad if left unregulated, because it rigs the game in favor of insiders. In the long run, this will discourage outsiders from investing at all, because they want to avoid losing money. If unmitigated insider trading activity dominates, then investors will eventually become jaded with investing in general and move onto other assets that promote fair trading activities.
For this reason, stocks have strict insider trading laws and processes that protect outsiders. The system is not perfect, but it at least incentivizes insiders not to trade on material non-public information. The punishment for insider trading activity is jail time, reputational damage, repatriation of profits, and severe fines, which is enough to scare most insiders.
In cryptocurrencies, however, there are no laws protecting outsiders. Why? Simply because regulations have not caught up to the rapid rise in cryptocurrency trading, and also many altcoin founders and exchanges operate outside of the U.S. in countries like Switzerland and Singapore. Many cryptocurrency exchanges also do not collect any identity information (name, national id), etc., which makes tracking and punishing the actual people behind unfair trading activities difficult. Not only that, these exchanges are currently not reporting suspicious activities to any government agency. Therefore, no government has any data to determine whether certain activities are illegal or not, or to convict anyone.
#2 The lack of deposit or security insurance
If you buy stocks at any U.S. broker dealer, both your cash and stocks are insured up to $500,000 each. Cash and stocks are insured by FDIC and SIPC, respectively. This means that if your brokerage (ETtrade, Fidelity, Charles Schwab) ever goes out of business and wipes out your deposits, then the government will reimburse you (up to $500,000). This insurance provides significant peace of mind to stock investors.
Cryptocurrency exchanges, however, do not provide either cash or asset insurance. The only exceptions are Coinbase and Gemini, which only insure cash deposits.
Cryptocurrencies are not even treated as legal securities in the U.S., meaning security insurance like SIPC does not apply. From a legal standpoint, cryptocurrencies are not legal tenders, which makes their status as asset equivalent to collectibles like Baseball cards or beanie babies. Thus, exchanges could lose all of investors’ cryptocurrency assets, and investors will not enjoy any government protection. This means cryptocurrency investors need to stay vigilant about the financial health and integrity of their exchanges.
#3 Not backed by any revenue, assets, or business model
Almost all publicly traded stocks are backed by companies that generate some revenue and assets. The same cannot be said of all cryptocurrencies and tokens, since most of them have been created out of thin air in the past year.
Take WeTrust tokens, for example. This company has not released any figures about either revenue, user base, or any tangible products since its founding in 2016. That did not stop it from having a market cap exceeding over $100 million. This valuation happened as a result of WeTrust promising its investors of the value of WeTrust’s product ecosystem, which essentially constitutes a pre-sale. With pre-sales, however, there is no real mechanism for holding the company accountable to fulfilling its promises to investors. The company can theoretically shut down shop one day without any warning and keep the funds it raised, and WeTrust’s investors will have little legal recourse. This type of fund raising would not have been viable in the public markets, which have much higher requirements for entry.
#4 The constant risk of irreversible, permanent loss
If hackers steal your private keys by breaching into your cryptocurrency exchange, then you can permanently lose all your money. And since cryptocurrency transactions are irreversible (because of Blockchain), this loss will be permanent, and nobody will be able to help you. Suing the exchange won’t help either since it can just conveniently declare bankruptcy.
So how common are security incidents at cryptocurrency exchanges and wallets? Far too common. Counting just the high profile hacks, more thanhas been stolen or lost in 2017. The actual losses are probably higher, since many thefts go unreported.
While scams and phishing also happen with stocks, stocks and deposits can’t just disappear permanently. Even if hackers somehow succeeded in wiring customers’ money to themselves, these wires can be reversed. Case in point, there hasn’t been an incident where a registered stock brokerage permanently lost customer funds or assets in recent memory.
#5 The lack of price consistency across exchanges & order protection
With stocks, you are guaranteed by the SEC that your limit orders aren’t filled by a worse price than the best offer or best bid across all exchanges.
With cryptocurrencies, the best bid offer is all over the place, and exchanges have no legal obligation to price match or price improve.
As a result, picking a good exchange is extremely important for trading cryptocurrencies.
Stock trading in almost all developed countries are regulated by strict investor protection laws. Cryptocurrency trading is completely unregulated, and most of them operate freely from any country’s jurisdiction. This lack of regulation has the following consequences for the average cryptocurrency investor.
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